There is an old saying, “It’s not the pace of life that bothers me; it’s the sudden stop at the end.” One could say the same of overbought, over-bullish, overly complacent markets.

If a market rises on solid fundamental drivers, there is no reason to fear collapse. If the rise is predicated on “greater fool theory,” however, that’s a different story. Flimsy structures tend to fall down much faster than they are built up. Just ask investors in Lehman Brothers... or Citigroup... or Iceland or Greece or Dubai.

This presents a problem for investors who are heavily long stocks (or even modestly long stocks). On the one hand, premature exit from long positions could be costly (by way of leaving upside on the table). On the other hand, getting caught in a meltdown could be worse.

How, then, to handle the risk of a market blow-up without fleeing to the sidelines prematurely?

There are all manner of techniques for hedging a portfolio; far too many to even scratch the surface in a single missive. Today we will talk about just one highly flawed, yet potentially useful, hedging tool: the S&P 500 VIX Short-Term Futures ETN (VXX).

Meet the VIX

Before we talk about VXX, though, we need to do a quick recap of what it more or less tracks – the “VIX,” or CBOE Volatility Index.

The VIX is known offhand as an “investor fear gauge.” All other things being equal, when investors are bullish and complacent the VIX is low. When investors are fearful (or panicked) the VIX is high.

The VIX works by tracking the 30-day “implied volatility” of S&P 500 options contracts. Implied volatility is a measure that considers how cheap or expensive an option is relative to a neutral benchmark. When investors feel nervous or scared, they are more willing to buy options as insurance – thus causing options to become “expensive,” and implied volatility measures to rise.

To get a mental picture, imagine S&P 500 put options as the equivalent of hurricane insurance on Florida beachfront property. When the weather is calm and sunny, the price of hurricane insurance will fall along with reduced demand. But when the weather is ominous and gale force winds are forming, the price will go up. The VIX is sort of like a “hurricane anxiety indicator” for markets.

The VIX has been around a long time. The above chart from Bespoke Investment Group shows the VIX dating all the way back to 1990.

See the giant spike that looks like the Empire State Building? That was the global financial crisis in full swing. The all-time lows for the VIX (i.e. max investor complacency) are right around 10. We saw those levels in late 2006, just before the crisis got rolling. The long-run average for the VIX is just above 20... and we are below that level now.

Tracking the VIX

Given all the risks out there, both economic and geopolitical, one could argue that fear is oversold right now (and greed substantially overbought).

In the event of a “sudden stop” – that is to say, an onslaught of investor panic that sends the market sharply lower – the VIX could rocket higher in a very short space of time. But how to take advantage of this fact?

Enter VXX, the S&P 500 Short-Term VIX Futures ETN (VXX:NYSE).

VXX is designed to track the CBOE Volatility Index – sort of. In actuality, you are getting a basket of VIX futures contracts. Here are some talking points from Standard & Poors:

· While VIX has achieved widespread recognition, it remains very challenging to replicate spot VIX. The S&P 500 VIX Short-Term Futures Index is the first index to offer replicable, directional exposure to volatility using exchange-listed futures contracts.

· The index is comprised of two near term VIX futures contracts, which are rebalanced daily in equal increments in order to maintain a constant one month maturity.

· While the correlation between spot VIX and the S&P 500 VIX Short-Term Futures Index is not perfect, it is a healthy 87%. More importantly, the correlation of the index to the S&P 500 is -76%, similar to the correlation of spot VIX to the S&P 500 of -74%.

· The index has a positive return 95% of the time that the S&P 500 has a loss of more than 1%. During days of sharp market declines, index returns are usually greater in value than corresponding S&P 500 losses.

Don’t Sit on It

VXX sounds very attractive at first blush. If one is concerned about, say, a potential “crash of 1987” type event, why not just buy a good chunk of VXX in the expectation that volatility will shoot through the roof?

The trouble is that, under normal conditions, VXX displays time-decay characteristics. It acts like an options contract, ebbing away premium day after day.

The creators of VXX are aware of this, noting that “Dedicated long positions in the index are expected to decline during normal volatility regimes... the index is also expected to suffer from roll loss due to termstructure decay.”

You can see this by looking at a chart of VXX stretching back over the length of 2009. It just about went straight down for the entire length of the rally! (This also makes sense given the extreme negative correlation of VXX to the S&P 500.)

So you can’t really just sock VXX away on any kind of long-term basis. The nature of the “roll” on the underlying short-term futures contracts, plus the slow grind of investor complacency, would eat away the value under normal conditions.

But at the same time, there is a potential hedging use for VXX if one properly accounts for the drawbacks.

In Case of Emergency

The conditions of the 2009 rally were the worst imaginable for an instrument like VXX. When volatility goes into steady, slow decline, so too do instruments designed to benefit from it.

But as we know, storm clouds can gather on a horizon rather quickly. If we cycle back to an environment of increased fear, VXX could benefit. If we get a full-on equity “crash” or “meltdown” scenario – in which someone yells fire in a crowded theatre and long-only managers stampede for the exits all at once – VXX will roar.

This makes VXX a sort of instant disaster insurance. While the cost of decay is too high to hold VXX on a long-term basis, on a short-term basis it functions as coverage you can buy quickly and easily if it appears a serious storm is coming.

Major market crashes are like hurricanes. We don’t get a whole lot of warning when they form, but we do get a little bit. With an instrument like VXX handy, a warning window of even 24 to 48 hours might be enough (about the amount of time beachfront property owners get when told it’s time to evacuate).

In sum, your editor suggests thinking of VXX as a sort of trading instrument... but not a trading instrument in the traditional sort of way. It is more a way to get exposure to pure volatility rather quickly, without the messiness of having to figure out, possibly while frantic, which index options to buy.

There are all kinds of reasons why one might expect (or fear) a massive surge in volatility for some imminent reason. A hot war escalation in the Middle East... a breakout of protectionist tensions with China... a threatened crackup of the eurozone or a downgrade of sovereign credit ratings... any of these possibilities, or dozens more, could warrant breaking the glass and purchasing a significant quantity of VXX on a short-term basis. (Then, too, there is the most frightening prospect – a sudden turn for the worse with no clearly defined catalyst at all.)

If the crisis moment passes with no crash, then VXX could be sold back again at modest cost. In this case, the long investor might view the play as “better safe than sorry”... hurricane insurance that was (fortunately) not needed this time. The speculator would treat it as any good speculation – as a matter of odds rather than outcome.

Warm Regards,

JL

Taipan Publishing Group

http://www.taipanpublishinggroup.com/

About the author:

Taipan Publishing Group

Taipan Publishing Group: Taipan Publishing Group offers investors a diverse selection of financial research services to help boost short- and long-term gains from today's global market boom. Our international team of financial investment experts expose top stock, emerging and frontier market opportunities before other investors can capitalize. Visit: www.taipanpublishinggroup.com

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